How is a portfolio's tracking risk calculated?

The calculation of a portfolio's tracking risk involves understanding how the returns of the portfolio deviate from a benchmark index. Tracking risk is specifically concerned with the volatility of the return difference between the portfolio and its benchmark.

The calculation provided in option C represents a common method to determine the portfolio’s tracking risk. It considers both the weights of the individual assets within the portfolio and their respective tracking risks. By squaring the tracking risk of each asset and multiplying it by the square of its weight, the calculation captures how each asset contributes to the overall risk of deviating from the benchmark. Taking the square root of the sum of these products provides the portfolio's overall tracking risk, reflecting the aggregated effect of all components.

The square root is a critical part of this approach because it converts the aggregated variance back into standard deviation, aligning the result with how risk is commonly interpreted in financial analysis. This makes the result more manageable and interpretable in terms of the risk associated with the portfolio relative to its benchmark.

The other options do not fully or accurately capture the nuances involved in calculating tracking risk. For example, the average of individual asset weights does not address the risk or volatility aspect at all, while the standard deviation of portfolio returns does not specifically link the portfolio’s returns